What the IRS Gets Wrong About DeFi and Crypto in Its Latest Tax Reporting Proposal

This op-ed is part of CoinDesk’s Tax Week, presented by TaxBit. The following is edited testimony of Blockchain Association senior counsel Marisa Coppel during a hearing on the proposed broker rulemaking on Monday, Nov. 13.

On Monday, Nov. 13, the Blockchain Association submitted comment in response to Internal Revenue Service (IRS) proposed rulemaking on reporting for digital asset transactions. The association's letter addresses issues related to centralized entities, some of which operate in a similar manner to traditional middlemen or intermediaries. They arguably fall within the definition of a broker.

In our letter, we suggest several modifications to the proposal as applied to centralized entities, including increasing the time to comply, reducing the breadth in reporting requirements and refraining from applying the regulations to non-fungible tokens (NFTs) and stablecoins.

However, this proposal also impacts decentralized finance (DeFi) and non-custodial wallet software developers. The proposal is overly broad and exceeds the U.S. Treasury Department’s statutory authority by pulling in participants who are not intermediaries or middlemen. Additionally, the proposal does not comport with Administrative Procedure Act (APA) requirements and would lead to constitutional rights violations.

See also: How a New Tax Proposal From the IRS Could Impact DeFi | Tax Week

This proposal sweeps in parties whose only means of compliance would be to abandon the decentralized technology that makes them unique. This construction will drive all U.S.-based decentralized projects abroad or out of existence, full stop. Compliance with this proposal would require centralization where none exists.

It is also wholly unclear as to whether certain participants have a reporting requirement at all – the language is vague, which would further make compliance impossible. And make it far more challenging for the IRS to achieve its goal of increasing compliance with tax reporting.

The proposal’s definition of “broker” should be limited to centralized entities, who can collect such information. This is what Congress intended when it initially set forth the clarified definition two years ago. And this is how the tax code’s broker reporting rules have functioned historically.

While the Biden administration's Infrastructure Investment and Jobs Act (IIJA) was under consideration, Congress proposed a broader formulation of the definition of “broker,” which explicitly included “any decentralized exchange or peer-to-peer marketplace.” But Congress ultimately rejected that language.

Fast-forward to now, in this proposal, the IRS seems to have improperly read that language back into the definition of a “broker” by creating cascading, expansive terms in a way that dramatically departs from the concept of a middleman and the rules applicable to traditional assets. In particular, the regulatory proposal significantly expands certain terms and revises the definition of “broker” beyond the statutory definition.

The proposal’s definition of a “digital asset middleman,” for instance, pulls in any person providing a “facilitative service” who would “be in a position to know the identity of a party that makes the sale and the nature of the transaction.” This includes those who provide a service that “directly or indirectly effectuates a sale of digital assets.”

The terms “indirectly” and “in a position to know” would likely include developers of both decentralized finance and non-custodial wallet software, who are incapable of complying with broker reporting rules. Both types of software merely allow users to either connect and transact with one another, or with a smart contract itself.

In fact, software for decentralized applications does not “effectuate” transactions like a broker. And developers of such software certainly do not have access to the information required for reporting.

But this proposal fails to recognize the value of both decentralized and non-custodial software. Decentralized technology eliminates the intermediary or the traditional middleman, who necessarily carries risk. These risks include cybersecurity and data breaches, the risk of holding so much sensitive data under one person’s control, fraud and mismanagement.

Further, when you look at transaction functionality, centralized data storage it is often slow, cumbersome and inefficient. And it is expensive.

DeFi, however, eliminates risks of failure under one point of control. It is more efficient and costs less for the user.

Similarly, non-custodial wallet software enables users to hold custody of their assets. These users are the only ones who have access to their assets, which reduces risk of abuse, fraud or insecurity of middlemen.

This proposal would destroy all of that value.

Given the impossible nature of compliance, these software developers will be forced to either shut down their projects, move outside the U.S. or so fundamentally change the nature of their projects that it eliminates the benefits of decentralized and non-custodial technology entirely.

Congress did not express an intent to destroy DeFi. These issues are so profound as to raise significant Constitutional, Administrative Procedure Act and statutory authority questions.

The APA requires a reviewing court to set aside agency action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law,” “contrary to constitutional right,” “in excess of statutory jurisdiction,” or “unsupported by substantial evidence.” The proposal, if finalized, would fail each requirement.

Given the impact on DeFi and non-custodial wallet software in the U.S., clear Congressional authorization is required before the Treasury would have authority to require such reporting. Treasury has also not supported the proposal with substantial evidence or quantifies the costs or the benefits, as required by the APA.

See also: The IRS Should Offer a Free Tax Reporting Tool to DeFi Users | Opinion

Nor does the proposal estimate the cost burden on Treasury to process billions of new filings. Further it is unlikely extending third-party tax reporting would help quantify or close the supposed “tax gap.” This is to say nothing of the several constitutional concerns that would likely lead a court to invalidate it.

Given these issues, we urge the Treasury to adopt in the finalized regulations a staged approach that focuses first on centralized trading platforms. Centralized trading platform reporting alone would achieve the IRS’s goal of improving tax compliance, especially given that the vast majority of trading volume occurs on centralized exchanges.

After that, we recommend the Treasury work with DeFi participants to find workable solutions that do not hinder the development of this technology that is already changing for the better the way our financial system functions.

The U.S. prides itself on fostering innovation and also protecting civil liberties. We hope that the Treasury considers how this proposal can keep those American values intact, rather than destroy them.

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